1031 EXCHANGE TAX BENEFITS – WHAT YOU NEED TO KNOW
Real estate investing can feel like a dream sometimes. Your property is appreciating, you claim depreciation on your income taxes. They’re cash-flowing, and providing extra income for your family. What investors can be surprised to hear are the taxes they’ll owe when they sell. With regular investments like stocks and bonds, you pay capital gains. This is the difference between your purchase price and your eventual sale price. Unfortunately, there’s much more to consider when it comes to investment properties.
What investors can be surprised to learn when they sell is depreciation recapture is also taxed – and at higher rates! Not only will you owe capital gains and depreciation recapture, you could owe even more for attached items that have a faster depreciation schedule. If you’ve never heard of depreciation recapture, this article is for you. First, we’ll look at an example of the average real estate investor and taxes they’ll owe. Then, we’ll explain the 1031 exchange tax benefits in detail. You’ll walk away with knowledge about how to reduce real estate taxes the next time you sell a property.
1031 Exchange Example – More Tax Benefits than you think
Let’s say a fictional investor “Shayna” is looking to sell her investment property. It’s a triplex in Kansas City, MO that she bought ten years ago for $400,000. Shayna originally allocated $360,000 to the building’s value, and $40,000 to the land. Since you cannot depreciate land, $360,000 will be the amount deducted in equal amounts for 27.5 years. Shayna has taken $13,333/year of depreciation, or $1,111/month for the past ten years.
The first ten years Shayna’s owned the property have been great! It has cash-flowed $200 a month and appreciated a lot. The fair market value is now $600,000! Even better, Shayna has taken $133,333 in depreciation, which has reduced her income in the eyes of the IRS. The only bad part is when Shayna goes to sell the property. Her accountant says her tax bill will be $73,333.25. Shocked, Shayna wonders how this could be when the property has only appreciated by $200,000. She figured that since it’s a long-term capital gain, the tax rate would be (.2*200,000)=$40,000.
Why is the tax higher than expected?
What Shayna didn’t realize is that when “The IRS giveth, the IRS taketh away.” Basically, Shayna has been enjoying a depreciation-fueled tax break for the past ten years. Now, the IRS wants that money back upon sale. Here’s how the IRS figures this out:
In addition to regular capital gains (Sale Price – Original Price), the IRS says that any depreciation you take makes your “cost basis” lower. Using Shayna’s example, instead of the original cost basis of $400,000, the IRS “cost basis” is $266,667 (Original Price – Depreciation Taken). To add insult to injury, depreciation recapture is taxed at your regular income tax rate, up to 25%. Our examples assume your long-term capital gains rate is 20%, and depreciation recapture is 25%.
So when Shayna goes to sell her property, she should be accounting for the capital gain of $200,000, taxed at 20%. Then, she needs to add depreciation $133,333 taxed at 25% to this total. Seem unfair? It might be, but the IRS isn’t in the morality game. They don’t care if you helped ten old lady’s across the street last week, they want their money.
1031 Exchange Tax Benefits
Who wants to pay $73k to the IRS when you sell a property? Not many hands up in the room…
Fortunately, there’s a way to defer paying taxes upon sale, and that’s through the 1031 exchange. By arranging with a qualified intermediary, you can buy a “replacement property” and not pay a single dime to the IRS. This is not a loophole, and it’s not a new technique. The 1031 exchange has been around since the 1980’s and hundreds of thousands, if not millions have been done in total. We’ll walk through the basics.
When you are preparing to sell your existing property, you should reach out to a qualified intermediary for a consultation. They’ll help you document all necessary steps during the process. Before the sale of your existing property is complete, you should decide if a 1031 exchange is right for your situation. If you decide it is, you’ll need to identify replacement properties within 45-days of the sale. Identification means that it’s a suitable property, and worth more than the proceeds from your existing property.
After you’ve identified the properties, you must close on one of these replacements within 180 days of the sale. Once you’ve done this, you’ll submit form 8824 on that year’s taxes. There’s quite a few steps that we’ve glossed over, but any reputable 1031 exchange company will help you through all of them.
You may be asking “won’t I just have a huge tax bill some day?” The answer is “it depends.” There are ways to continually do 1031’s until you die. The crazy part is that your heirs receive the properties on a step-up basis. This requires in-depth knowledge of the 1031, and some help from CPA’s and estate planners.